Copyright © Theodore G. Eppenstein, Madelaine Eppenstein
2006 New York, New York – All rights reserved
Originally Published as Op Ed Article in
The New York Times, Money and Business Viewpoint,
(Sunday, June 8, 1997)
What do you tell someone who says he lost his life savings to an unscrupulous stockbroker and now wants to sue in court and get a jury trial? There may be more than 10 million stock brokerage accounts out there, but the answer is, "Sorry, you can't go that route."
Ten years ago today [June 8, 1997], the Supreme Court, with the blessing of the Securities and Exchange Commission, locked the courthouse doors to such investors by granting the brokerage industry's wish that customer claims be limited to arbitrations conducted by industry tribunals.
In this landmark case, Shearson/American Express v. McMahon, the Justices in the narrow 5-to-4 majority found that the "bargained for" customer contract calling for mandatory arbitration of securities fraud disputes was enforceable. The decision proclaimed that the long-perceived mistrust of arbitration was, by 1987, a myth and that investors could get a fair deal in arbitration. In his dissent, Justice Harry A. Blackmun said the decision was "animated" by a desire to pare down the Federal court docket. And he asserted that investors should not lose their day in court at the whim of the industry and predicted that more litigation would ensue. This analysis has proved prophetic.
In the years that followed, the S.E.C. investor advocates, the Securities Industry Conference on Arbitration and the industry itself have been involved in a continuing effort to reform the process. There were some early and positive changes in the rules governing arbitration proceedings at the tribunals of the major self-regulatory organizations, the National Association of Securities Dealers and the New York Stock Exchange. For instance, all important information and documentation exchanges were once permitted to languish until the first day of a hearing; now the exchange of evidentiary material is slugged out by the lawyers before the arbitrator-referees well ahead of the hearings on the merits.
But substantive improvement has been slow, and a perception remains that arbitration is a stacked deck. Skepticism persists largely because the rules require a person affiliated with the industry to sit as an arbitrator on every three-member panel.
The industry asserts that it is better for the customer to have an individual knowledgeable about the workings of the market sitting in judgment of fraud claims. But the public suspects that an industry arbitrator wi1l have difficulty determining impartially whether another firm engaged in fraudulent activity like unauthorized trading, unsuitable investing or churning. And will that industry arbitrator have the courage to render a multimillion-dollar award, including punitive damages, against another member of the Wall Street club? An industry arbiter who does that risks being blackballed by the industry in his career and in future cases.
But there is no need for the purported expertise of the industry "Solomon" on these panels because most disputes turn on the credibility of witnesses, not on technical trading issues. And our judicial system has generally functioned well over the centuries by leaving it up to lay jurors to understand even the most complex disputes.
The industry, which forced arbitration on investors – and which could stop forcing it anytime by removing the mandatory arbitration clauses from customer contracts – has tried in recent years to frustrate arbitration by going to the very courts it seeks to prevent its customers from using.
The most pernicious tactic has been to initiate litigation requesting state court judges in New York to dispose of customer claims before they reach arbitration, often regardless of the residence of the investor. Lawsuits by the hundreds were filed and temporary restraining orders were obtained stopping arbitration in its tracks while New York judges were asked to decide defense issues of statutes of limitations, redundant "eligibility" rules in arbitration and whether investors could proceed to argue for punitive damages. This wasteful and delaying tactic has continued, although it appears from recent decisions that New York's judges are tiring of it.
One legacy of Shearson v. McMahon is that arbitration for public investors has become more like court litigation, but without the safeguards built into the judicial system. As a result, the broker-dealers have devised strategies to frustrate the proceedings.
An early reform was to liberalize the discovery phase before the hearings. The industry has seized upon this as an opportunity to harass claimants and prolong the proceedings. Document requests are now a lengthy list that the broker-dealer churns out of its word processor. The most personal information is demanded, along with data about every investment the Claimant ever made.
Often, brokers also string out the discovery process when it comes to providing documents requested by investors. Despite repeated pre-hearing conferences, there are many cases in which the most important documents are not produced until the end of the process, and sometimes not even until the trial begins.
We are sure that one of our adversaries maintains an antique photocopier solely for use in providing illegible copies in response to customer requests. In one case, we fought for the right to see the original as well as the photocopy we had been furnished. When we finally got to look at it, it turned out to be the smoking gun. On the original, it could be seen that the word "no" had been erased at a crucial point. The erasure had not been apparent on the copy. The brokerage firm's settlement offer was ultimately doubled.
There are now two controversial proposals that the N.A.S.D. may send up for S.E.C. approval: a cap on punitive damage awards, and an opportunity for the industry, in claims based on activity more than six years old, to choose unilaterally to kick the Claimant out of arbitration.
The punitive damage cap (the lesser of $750,000 or two times the compensatory loss), is perhaps the most disturbing of these proposals, especially when the most recent court decisions allow unrestricted punitive damages. Apparently, it is not enough to force customers to arbitrate rather than go to court. The N.A.S.D. also thinks that the industry should be able to impose what it views as a fair limit on what the arbitrators can award.
This is not the "justice" that the Supreme Court, in 1987, envisioned as a fair, fast, cost-effective alternative method of resolving disputes. Ideally, Congress should recognize that and undo the McMahon decision.
But if forced arbitration is to continue, changes are needed. There should be no six-year eligibility limit because brokers are fully protected by applicable statutes of limitations. The right to punitive damages should be made crystal clear, and arbitrary limits on them not allowed. The pool of arbitrators should include more of a cross-section of the investor's community, and the industry arbitrator should be removed unless the investor requests otherwise. And abuses to the discovery process should not be countenanced.
Given the power of the securities industry to fashion its own rules, and the inability of investors to have a real say in the administration of arbitration justice, there will no doubt be further erosion of public confidence in the system if the system is not improved.
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